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The Current State of the Japanese Economy: a Macro-Economist's View

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The Current State of the Japanese Economy: a Macro-Economist's View October 2009 The Current State of the Japanese Economy: A Macro-Economist’s View Koichi Hamada (Professor, Yale University) I am quite concerned with current Japanese macro-economic policies that seem to contradict sound principles of economics. These short essays are designed for English reading audiences, in order to enable them to consider a different perspective. While these essays are actually “companion” pieces, each can be read as a “stand alone” essay. I thank the NIRA (National Institute for Research Advancement), its Chairman, Jiro Ushio, and its Director of Research, Reiko Kanda for giving this valuable opportunity to post them1. Table of Contents: 1. The Sub-Prime Crisis from Both Sides of the Pacific: A Modern Aesop Fable 2. The Flight of the Japanese Economy with One Engine: Fiscal Policy Without Monetary Policy 3. A Nightingale Who Does Not Sing: The Bank of Japan Pursuing Systemic Stability Without A Monetary Policy 4. Where Will the Democratic Party of Japan (DPJ) Lead its Macroeconomic Policies? (forthcoming) 5. On Policy Coordination, Carry Trade and the Sun-Spot Equilibrium (forthcoming) 1 This paper contains an English version of three notes in Japanese, “Fuan wo Kaisho sureba nihon keizai nohinodemo tokunai (The Sun Goddess will rise again if we suppress the anxieties).” Weekly Ekonomisuto, May5-12, 2009; “Kin-yu Zaisei no yori Chowa no Toreta seisaku Un-ei.wo (Towards a more balanced mix of monetary and fiscal policies)” NIRA Policy Review, No.40, July, 2009.; and “Nichigin wa Sangyoukai wo Kurushimeteiru (The Bank of Japan makes industries suffer).” Boisu (The Voice). September, 2009. I thank the editors of these Reviews for allowing me to use parts of my articles. I owe Yasushi Okada of the Japan Cabinet Office for his discussions and for his collaboration in drawing Figures below. 1 <Essay I> The Sub-Prime Crisis from Both Sides of the Pacific: A Modern Aesop Fable “Once upon a time, on the East side of the Pacific, there was Country A that was inhabited by grasshoppers; on the West side of the Pacific, there was Country B that was inhabited by ants. Grasshoppers in Country A lived a high style of life because they had a secret bottle called “the cruse of Wall Street,” which was allegedly able to transform, by magic, risky real estate securities into a set of safe securities. Someone could put into the cruse, papers that were contaminated with dirt, and miraculously receive gilt-edged securities in return. The transformed, gilt-edged securities were labeled “sub-prime securities.” In this manner, grasshoppers could afford to enjoy presumptuous consumption beyond their means by borrowing from Country B. On the other side, ants in Country B worked hard to leave estates to their off spring. They were so pressed to increase their savings that they even bought the securities produced by the magic financial engineering. Suddenly, it was discovered that the magic of the Wall Street cruse was a fake. The processed securities, once appearing as gilt-edged turned out to be edged with dirt. Moreover, all those securities were labeled as AAA securities, and there was no way to distinguish securities that contained risky elements of default (landmines) and those that were free of them. What could grasshoppers do under these circumstances? And furthermore, what could ants do? I-1: Introduction This is a metaphorical picture of the current state of the sub-prime crisis. In the United States, a country of grasshoppers, the wealth that they thought they possessed has disappeared suddenly. The loss in the value of their assets requires adjustment in consumption. The most probable adjustment to this decline in permanent income is to 2 reduce consumption and improve the current account balance of payments while reconstructing the financial system. This change means that Country B, the ants, which may be represented by China or Japan, will also be seriously affected. If the U.S citizens suddenly reduce spending, then exports from China or Japan will substantially decrease. Through this process, China or Japan will share some of the burden that the U. S. economy imposed through the misperception of risks and returns in real estate loans. As in the case of Japan before her lost decade in the 1990s, the myth of ever rising real estate prices reinforced this misperception. Genuinely risky assets were regarded safe because of the ever rising real estate prices. China and Japan have long accumulated their foreign assets in the form of dollar denominated securities. Because of the predetermined accumulation of the dollar denominated securities (some economists call “the original sin,” whether appropriate or not), both the Chinese and the Japanese people have ended up in a capital loss situation. For example, China is reluctant to appreciate the Yuan, even if appreciating the Yuan is the right solution for coping with the inflationary pressure in China (conflicted virtue). As is indicated by the fable, not only the aspect of asymmetric information in finance but also the difference between the degree of time patience in U.S. and that in Japan or China was in the background of chronicle imbalance in the balance of payments. I-2: Volatile Asset Prices in the U.S. are Triggers for World Turmoil. It was difficult to blame other countries when Japan was in its lost decade during the 1990s. Japan’s problem started from its own. Some in Japan attributed the cause of deflation to low commodity prices exported from China and other countries, but that was wrong because Japan could chose more depreciated yen rates. The sub-prime crisis, on the other hand, began in the United States, while the Japanese and Chinese systems were functioning normally. Fundamentals in these neighboring countries were practically sound when the crisis started, except that they invested into the financial assets in the United States. This crisis is an imported crisis from the United States to Japan, China and other Asian nations. The malfunctioning of the United States market and the mishandling of the crisis by the U.S. government worsened the situation, and foreign trade partners now have to deal with the consequences of the U.S turmoil. In the stock dimension, the 3 epicenter of the earthquake was in the United States, and its waves were immediately transmitted to foreign asset markets as well as to the currency market. The sudden disruptions in the asset markets in foreign countries caused declines in the flow dimension, such as their exports, output, and finally in the labor market. Stock markets are aligned because capital can move freely around the world. This integration usually adds to the capability or dynamic efficiency in allocating consumption and investment around the world. On the other hand, huge capital movements are triggered by arbitrage possibilities with a very small margin of rate differentials, and the possibility of emerging bubbles becomes reality. Therefore, the present difficulties were not so much caused by structural problems in Japan’s domestic markets as by triggers from the U.S. financial market. Price movements in the stock market (assets) are abrupt and extremely volatile, while those in the flow market are slow. Interactions of immediate movements in the market of stock variables and slow movements in the market of flow variables create interesting but serious adjustment problems. I-3: Scenes in the U.S. in the Center under the Sub-prime Crisis. Let me compare the scenes in the United States where I regularly live, to the scenes in Japan where I occasionally stay. First, securitization has advanced in the United States. In Japan, university teachers’ pension funds do not invest in equities, but in the United States a part of college teachers’ pensions funds (CREF) invests in equities. Accordingly, as an aspiring retiree in a few years, I was alarmed when my wife watched the sudden reduction of my retirement capital as the total (fictitious) wealth of Lehman Brothers disappeared. The development of the sub-prime market had been beneficial to low income house holders. It was an erroneous belief, however, that mixing and manipulating these risky loans by financial engineering could craft derived assets with safer and much higher returns. Second, worship on Wall Street remains strong. Many Yale students still favor applying to financial sector jobs. In spite of the fact that firms are to receive government “help,” that is, Federal tax money, chief executives do not find it awkward to fly to Washington D.C. in private jets, nor do they consider it inappropriate to also pay large bonuses to 4 executives. Those privileges are entitlements as well as rewards to winners of tournament competition. What a vastly different scene it is from the one in Japan where chief executives bow deeply to tax payers as apology! Third, in a parallel way, the trust in financial markets has been, and is now, strong. Any dynamic optimization course begins with the assumption that the agents observe the non- Ponzi-game condition. In Japan the pyramiding scheme is called nezumi-ko, a “multiplying” scheme. I-4: Scenes from Japan Where Fires Were Thrown from Abroad Whenever I return to Japan, I am impressed that Japan is full of consideration for old, sick, and disabled people. Under this spirit of warmness, or sometimes conceited warmness, and under the electoral system that magnifies the voting power of residents in rural areas, public expenditures were distributed to rural areas during the long reign of the Liberal Democratic Party (LDP). The new incumbent Democratic Party of Japan (DPJ) will be likely to reinforce this trend. In each city, the local government has built an art museum, concert hall, and recreation facility independently.
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